The discounted cash flow valuation guide explains the theory: a business is worth the present value of its future free cash flows. This guide shows how to build a DCF model in a spreadsheet — the layout, the driver-based forecast, the discounting mechanics, the terminal value, the bridge from enterprise value to equity value and the sensitivity table that every DCF should include.
What you will learn
- Lay out a DCF model with clear inputs, forecast, valuation and outputs
- Build free cash flow to the firm from operating drivers
- Discount cash flows and calculate terminal value correctly
- Bridge to equity value per share and present sensitivity
Step 1: Set up the inputs
Keep every assumption in one input block, with units and sources:
| Input | Example value |
|---|---|
| Base-year revenue | 1,000 |
| Revenue growth, years 1–5 | 8%, 7%, 6%, 5%, 4% |
| EBIT margin | 15% |
| Tax rate on operating profit | 25% |
| Depreciation and amortisation | 4% of revenue |
| Capital expenditure | 5% of revenue |
| Net working capital | 10% of revenue |
| WACC | 12% |
| Long-term growth | 4% |
| Net debt | 250 |
| Diluted shares | 50 |
All figures are illustrative. The WACC comes from a separate calculation — see WACC explained — and the growth assumptions from revenue forecasting.
Step 2: Forecast free cash flow to the firm
Free cash flow to the firm
FCFF = EBIT × (1 − tax rate) + D&A − Capital expenditure − Increase in net working capital
Worked example: five-year forecast
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|
| Revenue | 1,080.0 | 1,155.6 | 1,224.9 | 1,286.2 | 1,337.6 |
| EBIT (15%) | 162.0 | 173.3 | 183.7 | 192.9 | 200.6 |
| NOPAT (EBIT × 0.75) | 121.5 | 130.0 | 137.8 | 144.7 | 150.5 |
| + D&A (4%) | 43.2 | 46.2 | 49.0 | 51.4 | 53.5 |
| − Capital expenditure (5%) | 54.0 | 57.8 | 61.2 | 64.3 | 66.9 |
| − Increase in NWC (10% of revenue growth) | 8.0 | 7.6 | 6.9 | 6.1 | 5.1 |
| FCFF | 102.7 | 110.9 | 118.6 | 125.7 | 132.0 |
Capital expenditure exceeds depreciation in every year — consistent with a growing business — and working capital rises with sales. For a full company model, these lines would come from an integrated three-statement model.
Step 3: Discount the forecast
Use discount factors of 1 ÷ (1 + WACC)^t, with t counted from the valuation date to each cash flow.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|
| Discount factor at 12% | 0.8929 | 0.7972 | 0.7118 | 0.6355 | 0.5674 |
| Present value of FCFF | 91.7 | 88.4 | 84.4 | 79.9 | 74.9 |
Sum of present values: 419.3.
Mid-year convention: cash flows arrive throughout the year, not on the last day. Many practitioners discount each year’s cash flow by (t − 0.5) years, which raises the value by a factor of about 1.12^0.5 ≈ 1.058 for a 12% rate. Whichever convention is used, state it.
Step 4: Terminal value
Worked example: terminal value and enterprise value
Perpetuity growth method: TV₅ = FCFF₅ × (1 + g) ÷ (WACC − g) = 131.96 × 1.04 ÷ 0.08 = 1,715.5.
Present value: 1,715.5 × 0.5674 = 973.4.
Enterprise value = 419.3 + 973.4 = 1,392.7. The terminal value contributes about 70%.
Cross-check with an exit multiple: year-5 EBITDA is 200.6 + 53.5 = 254.1, so the perpetuity terminal value implies an EV/EBITDA multiple of 1,715.5 ÷ 254.1 = 6.75×. If comparable companies trade at very different multiples, revisit the growth or WACC assumptions.
Make sure the final forecast year is a "steady state": growth in year 5 matches long-term growth (4% here), and reinvestment is consistent with that growth. Otherwise the terminal value inherits unsustainable assumptions.
Step 5: The equity bridge
| Enterprise value | 1,392.7 |
| Less net debt (borrowings, leases, less cash) | (250.0) |
| Less minority interests and other claims | — |
| Equity value | 1,142.7 |
| Diluted shares | 50 |
| Value per share | 22.85 |
Use diluted shares (including options and convertibles that are likely to be exercised) and include all debt-like items at the valuation date.
Step 6: Sensitivity table
Build a two-way data table of value per share (or enterprise value) against WACC and long-term growth, as described in scenario and sensitivity analysis and Excel for finance. Add scenarios for the operating drivers — growth and margin — because they often matter as much as the discount rate. Present the result as a range, with the base case clearly labelled.
Step 7: Check and document
- Does FCFF reconcile with the cash flow forecast?
- Are the discount factors counted from the right date?
- Is long-term growth below WACC and below long-run nominal economic growth?
- Is the implied exit multiple reasonable?
- Are the input sources documented and the key judgements explained?
The NPV calculator and present value calculator are useful for checking individual pieces.
Common mistakes
- Using a terminal year that is still growing fast or reinvesting too little for its growth.
- Discounting at the wrong date or mixing year-end and mid-year conventions.
- Forgetting to deduct leases and other debt-like items in the equity bridge.
- Mixing nominal cash flows with a real discount rate.
- Presenting a single value without sensitivity.
Key terms
- FCFF — free cash flow to the firm, available to all capital providers.
- NOPAT — net operating profit after tax: EBIT × (1 − tax rate).
- Mid-year convention — discounting each year’s cash flow from the middle of the year.
- Equity bridge — the adjustments from enterprise value to equity value.
- Exit multiple — a valuation multiple used to estimate or cross-check terminal value.
Frequently asked questions
How many forecast years should a DCF have?
Enough for the business to reach a stable growth rate and margin — commonly five to ten years.
Should depreciation be included in FCFF?
It is added back because it is non-cash, but its tax effect is already reflected through EBIT. Capital expenditure is deducted instead.
Why do my DCF results change so much with WACC?
Because most of the value lies far in the future, especially in the terminal value. Small changes in the discount rate compound over many years.
Key takeaways
- Lay out inputs, forecast, valuation and outputs separately.
- FCFF = NOPAT + D&A − capital expenditure − increase in NWC.
- Discount forecast cash flows and a steady-state terminal value; cross-check with an exit multiple.
- Bridge to equity with all debt-like items, and always present sensitivity.
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- DCF Valuation: Enterprise, equity and per-share value.